Banking in China
China's move to open its banking sector to the West creates lucrative opportunities for foreign institutions, but they will have to tread carefully07/09/2007 | By TNE
When China joined the World Trade Organisation in 2001, it pledged to open up the country’s banking sector to foreign investors by the end of this year, a process that is requiring extraordinary levels of change. If it goes well, an influx of foreign banking skills into the domestic scene will aid the country’s rapid development. If it goes wrong, the results could be catastrophic – both for China and for its new foreign banking friends.
Early signs are promising. In 2003 foreign institutions owned just $500m of shares in Chinese banks, and held only about 1 per cent of China’s total banking assets, while China’s four largest state-run banks controlled over 60 per cent of the country’s loans and deposits. But official statistics now show that by the end of June, 26 overseas financial institutions held $18bn of shares in 18 Chinese banks and 71 foreign banks had set up 214 operations in China.
When the Bank of Communications made an IPO in Hong Kong it was oversubscribed 200-fold by retail investors and 20-fold by financial institutions. In July, the Initial Public Offering (IPO) of Bank of China, one of the big four state-owned banks, raised a record $2.5bn. And the China Securities Regulatory Commission (CSRC) is currently working on the flotation of other banking behemoths, including the Industrial and Commercial Bank of China – the country's largest commercial bank and – Agricultural Bank of China, another of the big four. Other recent IPOs to get away successfully include China Merchants Bank, the sixth largest lender on the Chinese mainland.
International investors have been quick to buy strategic stakes. Early movers included British-based Hong Kong and Shanghai Banking Corporation, which bought 19.9 per cent of the Bank of Communications for $2.25bn, and Bank of America, which picked up a 10 per cent stake in the China Construction Bank for $3bn. Meanwhile, the US-investment house Goldman Sachs paid $3bn for a 10 per cent stake in the Industrial & Commercial Bank of China. As such investments continue, it is estimated that by next year foreign financial groups will control one sixth of China’s banking system.
Foreign banks are positioning themselves to benefit from the tumultuous changes that will transform the Chinese banking sector over the next ten years. The Chinese banking sector faces a dramatic transformation over the next ten years. Its overall profits are likely to grow at an annual rate of about 10 per cent, according to a recent report from consultants McKinsey, but the source of its earnings will change significantly. The firm estimates that corporate banking's overwhelming share of the sector's profits will decline to little more than half as profits from retail banking increase more quickly. Three main forces will drive that change. First, says the firm, is the strong and increasingly consumption-driven growth in GDP, which has ranged between 7 and 9 percent in recent years. Prosperity will boost demand for retail-lending products such as car loans, credit cards, and mortgages.
Second, demand for traditional corporate-banking products, particularly deposits and loans, will fall. As Chinese companies centralise their cash management, the "stocks" of deposits held by each of their provincial operations will be greatly reduced. And Chinese companies that now rely almost entirely on bank debt for financing will use the developing capital markets to find alternative forms of finance, predict McKinsey. Finally, over the next five to seven years the Chinese government will gradually deregulate interest rates – a move that will significantly reduce margins on both deposits and corporate lending. “The shift in the profit mix from corporate to retail gives foreign banks a golden opportunity to tap into the Chinese banking market by targeting affluent,” says the firm. “Their financial needs are diverse, and they account for the vast majority of auto, mortgage, and personal-lending balances.”
McKinsey reckons that although they make up a mere 2 per cent of the retail customers of Chinese banks, these customers account for as much as 55 to 65 per cent of retail-banking profits. The larger "mass-affluent" segment – about 18 per cent of all customers – provides around 40 to 50 per cent of retail-banking profits. The majority of customers – the 80 per cent representing the mass-market – are “largely unprofitable,” the firm reckons.
The opportunity for foreign banks to cream off the most profitable customers is enormous. “Domestic banks can't serve this segment effectively, because they lack risk-assessment skills in retail lending and a sales-and-service culture in their operations, which focus primarily on processing deposit account transactions,” says McKinsey. “Some of the large institutions don't even know who their affluent customers are, since they have little integrated information about the people who bank with them.”
McKinsey predicts that affluent Chinese customers will switch to banks providing better service, even at the cost of higher fees or interest rates. “Foreign banks, with their greater experience of serving the affluent market, are thus well positioned to capture this opportunity,” the firm says.Importantly, foreign banks can serve the affluent market with a relatively small number of branches. That’s because the most affluent customers are highly concentrated geographically. Three-quarters of them live in Beijing and in major coastal cities such as Shanghai and Guangzhou.
Consequently, McKinsey predicts that a critical component of a winning strategy in China will be the creation of wholly owned branch networks. Leading foreign banking groups such as Citibank and HSBC are doing this already, building their own branch networks in central locations and luring top customers. These branches are still limited by regulation to foreign-currency deposits and loans, mainly to expatriates and affluent locals. But McKinsey notes that deregulation scheduled for 2007 will leave them free to take local-currency deposits and to offer credit cards, mortgages, and other personal-lending products in local currency — a market whose profits it says are likely to grow by 30 per cent a year.
To compete, foreign banks will have to form partnerships with Chinese institutions because most product markets are now closed to them. “An alliance is the only way to get in early, become acclimated, and master the skills needed for success,” says McKinsey. “What's more, if market conditions change and the government alters its regulatory agenda with a view to limiting the expansion of foreign banks, partnerships are less likely to be affected. With them in place, the foreigners can pounce if opportunities arise early and stay ahead of the curve if the markets develop according to script.”
International financial firms may be shovelling money into the Chinese banking sector, yet, paradoxically, the institutions they are seeking to partner with are weighed down by huge bad debts and many of them are technically insolvent. The capital adequacy ratio of the four largest state-controlled banks was only 4.6 per cent in 2003, compared to the 8 per cent international standard. In fact, China’s recent banking history is riddled with instability.
China only had one bank up until 1978 – the People’s Bank of China – and didn’t create many others until the first wave of “market reform” in the 1980s. These new banks were technically “commercial,” but they still financed state-owned enterprises and social infrastructure, and they had to prop up the rural peasant class by making subsidised loans. Not surprisingly, they ran up huge bad debts, most of which were unrecoverable. The situation worsened in the mid-1990s, when a speculative property investment bubble burst. The state intervened, turned the People’s Bank of China into the equivalent of the country’s central bank, and introduced measures preventing banks from providing direct subsidies to the state or making loans to government that did not meet commercial standards.
The Asian economic crisis of 1997 and 1998 brought matters to a head. Fearing instability, the government halted banking reform and liquidated many of the bad debts owed by state-owned enterprises. It also issues bonds worth $33bn to prop up the capital bases of the country’s four largest state banks. There were also industrial privatisations and closures on a massive scale, and in the seven years up to 2005 some 60 per cent of the workforce of state-owned enterprises – a total 30 million workers – lost their jobs.
After joining the WTO in 2001, Beijing’s policy has been that the state banks would “grow their way out of the problem”. Their financial position, however, remains precarious. Pressure from the US and European powers to revalue the Yuan has led to a wave of speculative lending to Yuan-based real estate and industrial projects. Investors hoped to make a killing if the value of the Yuan increased.
According to the International Monetary Fund, high saving rates and cheap credit has contributed to speculative investment in China amounting to 40 to 45 percent of GDP. “In short, one basic problem in China is that the high degree of thrift that fuels such rapid investment growth has a low payoff because of the fragile threads holding the economic picture together,” said the IMF. “Providing cheap capital to enterprises, especially state-owned firms, requires low interests rates. Sustaining bank profits then requires correspondingly lower rates of return on deposits. Thus, maintaining economically unviable state enterprises and supporting them through the banking system results in large implicit costs.”
And the threat of bad debts is still there. Official statistics put non-performing loans of four largest state-controlled banks at the 15 per cent of total loans – the equivalent of $193bn. Unofficial estimates are much higher.
US Treasury Secretary Henry Paulson is lobbying for more foreign competition against China's cosseted banks. The US Treasury is pressing for foreign banks, insurers and brokers to be allowed to open up multiple branches in China, and for caps on foreign ownership of Chinese financial institutions to be scrapped. “Longer term, we all want the Yuan to be traded in a more competitive, open marketplace,” Paulson said over the summer. “To get there we need their financial system to be open and open to competition and then of course longer term, China needs to make the transition from an export-driven economy to one that consumes more,” he said.
Clearly, the sheer scale of the Chinese economy and populace present extraordinary opportunities for foreign banks, but they will need to tread carefully.
